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Consumer Staples Stock Outlook - Feb 2013 - Industry Outlook

The companies under the Consumer Staples sector sell
relatively low-priced products that consumers use frequently in
their daily lives, including food, beverages and products for
personal hygiene or household cleaning. The purchase of these
necessities is generally stable over time, irrespective of the
spending patterns or whether the economy is expanding or
contracting.

This is a defensive sector, as the outlook for its companies
would not change much with the economic cycle. We have seen that
lately, as these companies have been playing their role despite
concerns about the prolonged weak U.S. economy, the debt crisis
in Europe and the slowdown in China.

Consumer staples stocks have outperformed the S&P 500 as a
whole in the year-to-date and trailing 52-week periods, up +9%
and +18.4% in the YTD and trailing 52-week periods, compared to
gains of +6.4% and +10.8% for the S&P 500, respectively.

Many consumer companies are expanding focus to emerging markets,
while many are resorting to cost saving initiatives to survive
input cost pressures. The companies are also expanding their
portfolios through product innovations and acquisitions.

Expansion in Emerging Markets

With market saturation, low disposable income of consumers and
increased competitive activity in developed markets, many
companies are diverting their resources to explore emerging
markets. Though companies like
Coca-Cola
(
KO
) and
PepsiCo
(
PEP
) are witnessing improving volume trends in North America, driven
by increased marketing and advertising spending, we believe that
the markets of North America are relatively mature compared to
their untapped developing counterparts such as Brazil, India,
China, Mexico, Russia and Southeast Asia, which exhibit positive
consumer spending growth.

Moreover, we have seen that product demand has remained stable
for companies that are more exposed to fast-growing emerging
markets in comparison to the slow-growing and saturated developed
markets. Demand for convenient and branded packaged food is
growing in the developing countries, as middle-class consumers
shift to urban living. Thus, the rising pool of middle class
consumers in emerging markets represents a huge opportunity for
branded consumer companies.

However, growth in the emerging markets has been largely hurt by
currency headwinds for many consumer staples companies due to a
stronger dollar, which reduces the value of outside-U.S. sales.
But with improving standard of living in developing countries,
the companies are now focusing on increasing pricing to derive
profits, which was earlier difficult.

Beverage companies such as Coca-Cola and PepsiCo have invested
heavily in the emerging markets of India, Russia and China,
encouraged by the high-growth nature of these countries. However,
the slowdown in Chinese economy has hurt the return on
investments for companies.

Coca-Cola has already invested over $2 billion in India in the
last 18 years and has been witnessing double-digit business
growth in India aided by its top brands like Thumbs Up, Sprite
and Maaza. Over the next eight years, Coca-Cola, along with its
bottling partners, will make a further investment of $3 billion
to build consumer marketing, infrastructure and brands in India.

Coca-Cola also has plans to invest $4 billion in China over three
years starting 2012, invest $3 billion in Russia between 2012 and
2016, $8 billion in Brazil through 2016 and $300 million in
Vietnam between 2012 and 2015.

PepsiCo has invested $700 million in India since 2008. It also
plans another $500 million investment over the next three years.
Further, with the acquisition of Wimm-Bill-Dann in Sep 2011,
PepsiCo took control of the largest food-and-beverage business in
Russia, bringing the company closer to its strategic goal of
building a $30 billion nutrition business by 2020.

PepsiCo's strategic alliance with leading Chinese food and
beverage maker Tingyi Holding Corp. has created the number one
liquid refreshment beverage (LRB) manufacturing network in China,
and is expected to help PepsiCo to revamp its Chinese business.

H.J. Heinz Company
(
HNZ
) has a significant presence in India, China and Indonesia. Heinz
products, especially ketchup, sauces and infant nutrition goods,
are showing healthy growth in all of these markets due to brisk
demand. Management expects its businesses in China, Indonesia,
Brazil and Eastern Europe to each generate around $1 billion in
sales over the next 3-5 years, with emerging markets as a whole
to double its sales to around $5 billion.

Recently, Heinz agreed to be acquired by an investment group led
by Warren Buffett's
Berkshire Hathaway
(
BRK.B
) and private Brazilian investment firm 3G Capital for $28
billion, including debt.

Coffee giant
Starbucks Corporation
(
SBUX
) is also gaining popularity with consumers across China and the
Asia-Pacific region, which has grown 33% (in terms of revenue)
since 2010 and is expected to achieve meaningful business growth
over the next five years.

Starbucks has already entered the lucrative Indian market with
its first three store openings in Mumbai in Oct 2012 and a fourth
store in Delhi early this month. The company has also entered the
Vietnam market with its first store in Ho Chi Minh City on Feb 1.

Cost Reduction Initiatives

Most consumer staples companies are also undertaking several
strategic initiatives like the divestiture of low-margin brands,
improvement of the supply chain and implementation of
cost-reduction initiatives, in an effort to reduce the effects of
inflating commodity costs. Though cost inflation has subdued,
rising commodity and other input costs remain a drag on margins
of most of the companies in this sector, despite top-line growth.

Coca-Cola is undertaking various productivity initiatives to
streamline its cost structure and boost profitability. With the
launch of a four-year productivity and reinvestment program in
Feb 2012, the company plans to optimize its global supply chain,
improve effectiveness of global marketing and innovation, achieve
operating expense leverage, standardize information systems and
integrate North American bottling and distribution operations
acquired from
Coca-Cola Enterprises
(
CCE
). The program is expected to generate incremental annualized
savings of $550 to $600 million over the four-year period ending
in 2015.

PepsiCo also announced a restructuring program in Feb 2012, which
is expected to result in $3 billion productivity savings by 2015.
The program will include leveraging new technologies and
processes across operations, consolidating facilities,
simplifying organization structures, lowering layers of
management, workforce reduction of 3% and many more efforts.

Tobacco company
Altria Group's
(
MO
) cost reduction program of $1 billion is expected to deliver
$400 million in annualized cost savings by the end of 2013. The
company also reduced its workforce by 700 employees in Feb 2012
as a part of its restructuring program to reduce cost.

Another tobacco seller,
Reynolds American
(
RAI
), also remains focused to reduce cost. The company is expected
to save about $70 million annually by 2015 associated with
workforce restructuring done in the year 2012.

Philip Morris International (
PM
) has also announced a one-year gross productivity and cost
savings target for 2013 of approximately $300 million. Last year,
the company managed to exceed its one-year gross productivity and
cost savings target of $300 million primarily through the
rationalization of tobacco blends and product specifications and
other manufacturing and procurement initiatives.

Consumer products giant, Kimberly-Clark (
KMB
) is undertaking a cost savings program, FORCE (Focused on
Reducing Costs Everywhere), which is benefiting the company
through the continued rollout of lean manufacturing and supply
chain practices and the formation of a global procurement
organization. These initiatives generated cost savings of about
$240 million in 2009, about $370 million in 2010, about $265
million in 2011 and $295 million in 2012. Kimberly-Clark expects
$250-$300 million of cost savings in 2013.

Kimberly-Clark's pulp and tissue restructuring program focuses on
improving underlying profitability and return on invested capital
of its consumer tissue and K-C Professional businesses, which
have been facing declining profits for many years. Through this
program, Kimberly-Clark anticipates operating profit to increase
by at least $75 million in 2013 and at least $100 million in
2014.

Innovations

Consumer product companies need to innovate and upgrade their
brands to create differentiated value propositions for their
customers in order to remain successful.

PepsiCo's low calorie cola -- Pepsi Next, launched in July 2012
-- was successful. The company also utilizes new packaging to
shift consumers to more profitable purchases. Its 24-ounce can
for regular and diet Dew is generating good customer response.
The company's recent innovations at the premium end include
Quaker Real Medleys hot cereals, Stacy's Gingerbread and Stacy's
Cocoa and Lay's Stax potato chips. The new innovations are
expected to boost revenue growth and also enable increased price
realization in the long run.

Starbucks has also introduced new products to excite customers.
With the launch of its premium single cup domestic coffee machine
Verismo in Sept 2012, the company expects to significantly expand
Starbucks' presence in the fast growing premium single cup coffee
segment. Apart from coffee, the company opened four Evolution
Fresh juice stores across the U.S., in order to meet the needs of
the increasingly health conscious Americans. In March 2012, the
company launched a new energy drink, Starbucks Refreshers, thus
marking its entry into the $8 billion energy drink market.

Starbucks is also diversifying with the La Boulange bakery
acquisition to popularize the French bakery experience in the
U.S. markets. In addition, with the acquisition of Teavana in
late Dec 2012, the company aims to capture further share of the
$40 billion tea category. The company has also enhanced its core
food offering, which has jumped double digits in each of the last
two fiscal years.

The tobacco sector has also been active in innovation with the
development of new products which reduce the harm caused by
tobacco. Reynolds American's Zonnic nicotine replacement therapy
gum and the Vuse e-cigarette offer potential for long-term
commercial success. Zonnic gum saves smokers from the harmful
effects of tobacco, while Vuse e-cigarette delivers vapor and
taste and has potential for long-term growth.

OPPORTUNITIES

Despite macroeconomic headwinds, some of these companies have
been able to deliver impressive results and have the potential to
grow in the upcoming quarters. The improved business backdrop is
showing up in positive earnings momentum for consumer staples
stocks, resulting in a Zacks Rank #1 (Strong Buy) for
Green Mountain Coffee Roasters
(
GMCR
),
Tyson Foods
(
TSN
) and
Smithfield Foods
(
SFD
).

Coffee maker Green Mountain's performance turned around in the
fourth quarter of 2012 (ending September) from past few weak
quarterly results, driven by the success of Keurig Single Cup
Brewers, single serve packs (K-cups), and Keurig-related
products. The company's margins are improving with favorable
green coffee costs.

The company is focusing on its products through innovations and
upgrading its Keurig brewing system to attract more customers.
Green Mountain has raised its earnings guidance twice for fiscal
2013 in the last two quarters. Green Mountain appears to be well
positioned for growth in the future quarters.

Stabilizing coffee costs also improved the margins at Smucker's.
The company has witnessed year-over-year earnings growth in all
the three quarters of fiscal 2013 (ending April), driven by
company's strong portfolio of brands, focus on innovations and
promotional offerings. Moreover, strategic acquisitions have
broadened Smucker's presence across emerging markets and added
popular brands to its portfolio. The company has increased its
fiscal 2013 earnings guidance in the last two quarters,
reflecting the company's potential to drive profits in the coming
quarters.

Like Green Mountain, the consumer products giant P&G also had
a tough fiscal 2012 (ending June). However, the company has
implemented some meaningful changes to re-accelerate its top and
bottom-line growth to keep pace with its peers, which is
reflected in its two back-to-back solid quarterly results in
fiscal 2013. In addition, the company's cost savings and
productivity improvement initiatives have improved margins.

The world's largest cereal maker, Kellogg, has delivered solid
growth in earnings in all the four quarters of 2012, driven by
robust organic sales growth performance. Despite its sluggish
cereal business, challenges in Europe and rising input costs, we
are optimistic about Kellogg's solid brand positioning, its
geographic diversity and cost-saving efforts, especially its
supply-chain initiatives. Moreover, we are encouraged by the
growth potential of the Pringles snack business, which was
acquired in June last year from P&G.

Meat products processor Tyson has been witnessing strong momentum
in the last several quarters backed by its bright prospect in
beef and chicken business and consistent innovation towards low
fat meat production. Rising demand for chicken coupled with
positive pricing is helping the company reap wider margins. In
addition, Tyson is working on growing its prepared foods,
international poultry and value-added poultry businesses by
producing high quality foods by using innovative and
cost-effective processes.

Tyson's close peer Smithfield also has bright prospects ahead as
the company expects hog prices and the impact of grain costs to
ease in the upcoming quarters. Smithfield's results have been
suffering since last two or three years as a result of higher
grain costs and oversupply of hogs. However the company recovered
nicely in fiscal 2011 (ending April) and posted record revenues
in fiscal 2012, backed by the company's brand building
investments and innovation, restructuring initiatives, improved
packaging and production of healthier choices for consumers using
lean protein and natural ingredients.

Smithfield is also increasing its focus on consumer convenience
by introducing more ready-to-eat foods. Increased export volume
of fresh pork is also encouraging and we expect strong demand of
fresh pork in the upcoming quarters.

Hershey has solid growth potential driven by strong brand
positioning, strategic marketing investments in core brands,
disciplined innovation, lower cost inflation, improved pricing
and volumes and strong productivity. In fact, Hershey has
outperformed and delivered positive surprises in three out of the
four quarters of 2012 and has raised its guidance thrice in 2012,
highlighting its attractive earnings potential. The outlook for
2013 is also encouraging, especially the expectation of no cost
inflation this year.

WEAKNESSES

The macro-economic environment in the U.S. has remained
challenging and uncertain for quite some time now. The European
economy has also remained unfavorable. The pace of economic
recovery is relatively slow in U.S., whereas the consumer
environment in U.S. is recovering at a mild pace. In Europe, the
economic conditions are uncertain and China is also seeing some
slowdown. These global economic pressures are expected to
continue in 2013 and severely impact the companies in the coming
quarters.

For the global brewer
Molson Coors
(
TAP
), the acquisition of StarBev in Jun 2012 opened opportunities in
the attractive beer market in Central Europe. However,
unfavorable economic conditions in Europe will offset the gains
from the acquisition. Moreover, the company has been facing
continued decline in volumes in three major markets of U.S., U.K.
and Canada in the last three years.

Molson Coors has also spent on marketing and advertising for its
Miller Lite and the Molson Brands but this has not led to
consistent growth in volumes. The increasing raw material costs
of the company and the currency headwinds hurting the top line
also remains a concern.

We believe that tough global macroeconomic conditions and
declining volume trends will continue to drag the company's
performance in the upcoming quarters. Currently, the stock
carries a Zacks Rank #3 (Hold).

Mondelez International
(
MDLZ
), which focuses on the global food and snacks business of the
old Kraft Foods, missed on both the top and bottom lines in
fourth quarter 2012 mainly due to currency headwinds. In
addition, the gum and candy business has been suffering for the
last few quarters. Management does not expect the gum business to
stabilize in the coming quarters. The stock carries a Zacks Rank
#3 (Hold).

Beverage company
Dr Pepper Snapple Group
(
DPS
) has had a dismal 2012, posting a negative surprise in two of
the four quarters of 2012. The company missed the Zacks Consensus
Estimates for both revenue and earnings while just managing to
meet company expectations for the year.

Moreover, the company's weak volume growth, higher cost pressure
and lack of exposure outside the U.S. is concerning. The company
has been facing persistent weakness in the overall carbonated
soft drinks' (CSD) volumes in North America since the past few
months, which also remains a significant overhang.

Changing consumer preferences, increasing health consciousness
and growing regulatory pressures are affecting beverage sales. We
therefore prefer to avoid the stock for the next few quarters.
The stock carries a Zacks Rank #4 (Sell).

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